Wednesday, April 18, 2007

Because it is always a minor controversy during earnings season, here's what the OTS has to say on the subject of a thrift with a neg am portfolio:

Capitalized interest. Lenders may record negative amortization as income in the form of capitalized interest. The lender does not actually receive the negative amortization amount as a payment from the borrower. Under generally accepted accounting principles (GAAP) the lender may capitalize (add to the loan balance) the accrued but unpaid interest amount and recognizes it as income as long as thecapitalized interest is considered collectible. The collectibility of the interest depends on the borrower’s ability and willingness to repay to full principal and interest, which is influenced by the borrower’s ability to service the debt and the size of the loan relative to the property value. When borrowers consistently make only the minimum required payments on option ARM mortgages, the increasing capitalized interest balance may indicate increasing credit risk, as it might indicate declining borrower equity and the borrower’s inability to make fully amortizing payments. A high level of capitalized interest may also create cash flow or liquidity concerns for the lender.

Credit risk. LTVs can increase over time (if property values decline or the borrower chooses to make only the minimum required payments), which increases the credit risk to the association. Recast requirements are designed to prevent runaway LTVs. If property values do not appreciate and interest rates rise, all lenders may be adversely affected, but NegAm lenders face greater exposure because of escalating LTVs. Additionally, the reported earnings sometimes mask credit risk in a NegAm portfolio, where the association is accruing income at a higher rate than the borrower is paying on the loan. Traditional credit quality monitoring reports of point-in-time delinquency and default data may lag as indicators of asset quality problems because borrowers facing payment problems can opt to reduce their monthly payments without causing the loan to go delinquent or disrupting the income accrual on the loan. Therefore, a strong indicator of potential credit risk is the number of an institution’s option-ARM loans that actually negatively amortize.